EXPERIENCE INTERNATIONALITY EMPLOYABILITY

Cash flows and taxes

BFS2780_ semester 1_2018

Gladman Moyana

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 Learning Objectives

 Know the difference between book value and market value

 Know the difference between the way in which individuals and corporations
are taxed in South Africa
 Know the difference between average and marginal tax rates
 Know the difference between accounting profits and cash flow
 Know what is free cash flow and how to determine it from a firm’s financial
statements

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Lecture Outline

Important elements of statement of

financial position and income statement
(issue 1)
Taxes (issue 2)
Cash Flow ( issue 3)

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 Net Working Capital and liquidity
 Working Capital is a firm’s short term assets and liabilities
 Net working capital equals current assets less current liabilities
 Usually positive in a healthy firm
 Student reflection: What is the implication for the firm if net working capital
is positive
 Liquidity
>> Ability to convert to cash quickly without a significant loss in value

>> Liquidity therefore has two dimensions, ease of conversion and loss of value
>> Liquid firms are less likely to experience financial distress
>> But, liquid assets earn a lower return

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 Debt vs. Equity- some important concepts
 Accounting equation says : Owner’s Equity= Assets – Liabilities
 Implications of this identity:
 To the extent that a firm borrows, it usually gives (first) claim to firm’s cash flow to the lenders
 Equity holders will then be entitled to the residual (portion left after lenders are paid)
 The above equation makes sense from an accounting point of view
 From economic point of view it also holds: if the firm sells its assets and pays its debts,
whatever is left is for shareholders
 The use of debt in a company’s capital structure is called financial leverage, that is the more
debt a company has the greater is the degree of financial leverage
 Debts acts like a lever- magnifies gains, losses , potential for reward and financial distress and
business

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Market Vs. Book Value
 The balance sheet provides the book value of the assets, liabilities and
equity.
 Market value is the price at which the assets, liabilities or equity can
actually be bought or sold.
 Market value and book value are often very different. Why?
 Which is more important to the decision-making process?
 Inflation?
 The balance sheet provides the book value of the assets, liabilities and
equity.
 Market value is the price at which the assets, liabilities or equity can
actually be bought or sold(willing buyer, willing seller…arms ’length)

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Statement of comprehensive income
 The income statement is more like a video of the firm’s operations for a
specified period of time.
 You generally report revenues first and then deduct any expenses for the
period
 Matching principle – GAAP say to show revenue when it accrues and match
the expenses required to generate the revenue
 Income statement measures performance ( important for analysis and
interpretation of Financial statements)
 Net profit after tax is called “bottom line”
 Net profit after tax expressed per share is called Earnings per share(an
important metric for investors)

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Taxes
 Marginal vs. average tax rates
 Marginal – the percentage paid on the next rand earned
• Applicable to personal tax rates in SA
• Company tax rate is not stepped?
 Average – the tax bill / taxable income

 Other taxes (NB for capital budgeting)

Recoupment
Capital gains tax

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Recoupment:
 Recoupment is the “revenue part” or ordinary part of tax that is paid when
an asset is sold.
 This is essentially a pay back of all allowances granted by SARS on an
asset that was used in the process of manufacture.
 Recoupment is calculated as selling process less tax value
 Tax value is cost less allowances granted.
 Tax value is usually the same as base cost used for capital gains
taxation(base cost is cost less allowances)
 Example: A machine was bought for R200,000 on 1 January 2010 and
brought into use on the same day. It qualifies for a 20% allowance. It was
sold for R210,000 on 1 January 2012. What is the recoupment?

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 Capital gains tax
 Capital gains is the “capital part” or extra-ordinary part of tax that is paid when an
asset is sold.
 Capital gain is calculated as Proceeds less Base cost.
 Proceeds is a defined concept: Selling price less Recoupment.
Professor Wiseman's Tutorial note:
there is a relationship between capital gain and recoupment. Capital gain calculation
removes the recoupment already taxed from the Proceeds to be used for capital
gains tax.
 Base Cost equals: Cost less allowances( same as tax value)
 The inclusion rate of capital gains is 80%. The applicable tax rate(28%) is then
applied to the capital gain to be taxed (NB, refer class example below)
 Task: Calculate the capital gain inclusion (to be taxed in previous example)

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Tax rates, a class discussion
 Individuals

 Companies

 Micro enterprises

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 Statement of comprehensive income again.. The concept of
cash flow
 Accrual concept and matching means that the statement of comprehensive
income is not representative of actual cash inflows and outflows
 If the income statement is not a cash document, is it useful for Corporate
Finance decisions
 Non cash items cause profit to be different from cash flow

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The Concept of Cash Flow from Assets_ Approach 1

 We will look at how cash is generated from utilizing assets and how it is
paid to those that finance the purchase of the assets
 We can determine the value of cash from the firm’s assets by using the
analysis implied by the accounting equation(A=E+L)
 By the same token cash flow from firm’s assets=
 Cash flow to lenders + Cash flow to shareholders
 Cash flow from the assets is therefore an inflow of cash (source)
 Cash flow to lenders + Cash flow to shareholders will represent an
outflow(use of cash)

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The “claims approach” to valuation- an
alternative view of free cash flow

 Cash flow from assets = cash from from/to lenders plus cash flow from/to
shareholders
 Free cash flow= Cash flow from assets

Interest paid 200

Debt paid/redeemed 300
Share repurchases 700
Dividends paid 20
Cash flow from assets 1220

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Cash Flow From Assets_Approach 2
 Cash Flow From Assets (CFFA) = Cash Flow to Creditors + Cash Flow to
Shareholders
 Cash Flow From Assets (Free cash flow)
= Operating Cash Flow
– Net Capital Spending
– Changes in NWC(see below)
 Cash Flow From Assets = Free cash flow
 Statement of financial position based cash flows = statement of
comprehensive income based cash flows(NB)
Prof Wiseman’s tutorial note: Students should be wary of the application of these cash flow
concepts above in the evaluation of capital budgeting and free cash flow valuations, among
others. These decisions will require you to have an intimate understanding of cash flow
concept. Please commit this concept to your intellect!!!
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Elements of cash flow from assets
 Operating cash flow is cash generated from the firms’ normal activities
 Operating cash flow=Profit before interest and tax + Dep –Tax
 Accounting definition of operating cash flow?
Prof Wiseman’s Tutorial note:
Remember such applications of operating cash flow for free cash flow valuations as “
Operating cash flows will grow at the nominal growth rate” . You will not be able to
apply this principle to your valuation if you do not know what operating cash flow
is!!!

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Elements of cash flow from assets
 What Is the impact of using book value instead of cost of assets in
calculation of capital spending
 CAPEX?
 Prof Wiseman’s Tutorial note
 For some topics such as valuations an estimate for CAPEX might be question
specific. Use the specific instructions (if given)in the question to determine CAPEX.
Also there are accepted ways(used in practice)of estimating expansion and
maintenance of fixed capital Refer class discussion

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Elements of cash flow from assets
 Change in net working capital
 Ending net working capital less beginning working capital
 Cash flow to lenders and shareholders
 Net payment to lenders and shareholders
 Cash flow to lenders= interest paid+ loans repaid(-loans raised)
 Cash flow to shareholders= dividends paid- equity raised(equity bought
back)

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More on approach 2- definition of FCFF and
FCFE
 Free cash flow to the firm defined as cash flow
available to all suppliers of capital for a firm after all
operating expenses including tax, CAPEX and
working capital
 Free cash flow Equity is defined as the cash flow
available to shareholders only after all operating
expenses including tax, interest, net borrowing,
CAPEX and working capital requirement.

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Computing Free Cash Flow to the Firm (FCFF)using the Net
Profit (Income)Approach
 A1. Computing FCF from Net Income
 Net Income
 Plus Non cash charges (Dep etc)
 Plus interest expense after tax = interest(1-t)
 Adjust for Non operating items
 Cash taxes (generally no adjustment)
 Less investment in working capital
 Less net Investment in fixed capital to maintain and expand

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Computing Free Cash Flow to Equity(FCFE) using the Net
Profit (Income)Approach
 A2. Computing FCF from Net Income
 Net Income
 Plus Non cash charges (Dep etc)
 NO ADJUSTMENT for interest expense after tax
 Adjust for Non operating items
 Cash taxes (generally no adjustment)
 Less investment in working capital
 Less net Investment in fixed capital to maintain and expand
 Add Positive Net Borrowing

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Computing Free Cash Flow to the Firm (FCFF)using the Profit
before tax Approach
 B1. Computing FCF from Profit Before Tax
 Profit before tax
 Plus Non cash charges(Dep etc)
 Plus interest expense before tax
 Non operating items
 Adjust for Cash Tax
 Less investment in working capital
 Less net Investment in fixed capital to maintain and expand

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Computing Free Cash Flow to Equity (FCFE)using the Profit
before tax Approach
 B2. Computing FCF from Profit Before Tax
 Profit before tax
 Plus Non cash charges(Dep etc)
 SUBSTRACT INTEREST EXPENSE BEFORE TAX
 Non operating items
 Adjust for Cash Tax
 Less investment in working capital
 Less net Investment in fixed capital to maintain and expand
 Add Positive Net Borrowing

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Computing Free Cash Flow to the Firm (FCFF)using Sales
Approach
 C1 Computing FCF from Sales(pick only cash items and tell examiner
 Start with Sales
 Tell examiner that you excluding Non cash charges(Dep etc)
 Tell examiner that you are excluding interest
 Tell examiner that you are excluding Non operating income not in your starting point
 Adjust for Cash Tax
 Less investment in working capital
 Less net Investment in fixed capital to maintain and expand

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Computing Free Cash Flow to Equity (FCFE)using the Sales
Approach
C2. Computing FCF from Sales(pick only cash items and tell examiner
 Start with Sales
 Tell examiner that you excluding Non cash charges(Dep etc)
 Subtract Interest
 Tell examiner that you are excluding Non operating income not in your starting point
 Adjust for Cash Tax
 Less investment in working capital
 Less net Investment in fixed capital to maintain and expand
 Add Positive Net Borrowing

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Computing Free Cash Flow to the Firm (FCFF)using Cash
flow from operating activities
 D1. Computing FCF from Cash flow from operating activities
 Start Cash flow from operating activities
 Tell examiner that Non cash charges(Dep etc) have already been adjusted for in starting point
of valuation
 Add back interest if it was classified as an operating activity(IAS 7)
 Exclude Non operating income not in your starting point
 Tell examiner that no adjustment for Cash Tax as it was already accounted for
 Tell examiner that no adjustment for investment in working capital as it was already accounted
for
 Less net Investment in fixed capital to maintain and expand(only adjustment needed)

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Computing Free Cash Flow to Equity (FCFE)using the Sales
Approach
D 2: Computing FCF from Cash flow from operating activities
 Start Cash flow from operating activities
 Tell examiner that Non cash charges(Dep etc) have already been adjusted for in starting point
of valuation
 No adjustment if interest was classified as operating activity. If it was classified as
financing activity subtract it
 Exclude Non operating income not in your starting point
 Tell examiner that no adjustment for Cash Tax as it was already accounted for
 Tell examiner that no adjustment for investment in working capital as it was already accounted
for
 Less net Investment in fixed capital to maintain and expand(only adjustment needed)
 Add Positive Net Borrowing

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